Beware of Single-Country ETFs

The market for exchange-traded funds is booming, and there's no sign of a slowdown in new issues. Just this week, three new single-country ETFs hit the market -- iShares MSCI Indonesia ( EIDO), iShares MSCI Ireland (EIRL) and iShares MSCI USA (EUSA). Investors now have more than 900 ETFs to choose from, and all told, they could reach $900 billion in assets this year if the money keeps pouring in.

The reason ETFs are so popular: Like mutual funds, they tempt you with an easy way to diversify your portfolio, they provide easy access to foreign markets and fees tend to be minimal.

But not all ETFs are created equally, and if you think you can profit from the debt crisis in Europe buy investing in single-country funds, be careful. There are over 50 single-country ETFs, which are packaged to trade as one stock and give you exposure to foreign stocks on a country-by-country basis, as opposed to broad and regional ETFs, which can include stocks from multiple countries. No doubt, some -- especially those that invest in emerging markets -- look attractive.

Single-Country ETFs May Lack Diversification

But single-country ETFs can be risky for the simple reason that many countries just don't have a wide variety of industries and companies. With all single-country ETFs, investors should realize that they bring exposure to political, social and human rights issues, for example, in China, and possible inflation in India.

Also, when you invest in a single-country ETF, know that you'll likely have higher expense ratios than if you invest in broader ETFs. The largest 20 single-country ETFs have average expense ratios of 0.60%.

On top of that, you may also be exposing your portfolio to a significant movement in a particular sector. If you buy Market Vectors Russia (RSX), for example, you'll be 40% allocated in energy. If you buy the iShares MSCI Japan Index Fund (EWJ), you'll end up with heavy exposure not only to the auto industry but to Toyota (TM), which is a significant holding of the ETF. During the first couple of months of this year when Toyota's recall nightmare made headline news, the fund was down about 6%.

A couple more examples: MSCI South Korea Index Fund (EWY) has 18% of its holdings in Samsung, and the MSCI Spain Index (EWP) has 22% of its holdings in Banco Santander SA.

Danger in European ETFs

Tendia Musikavanhu, CEO of Old Mutual Global Index Trackers, says ETFs focused on China and Brazil are the most attractive, but so too are Brazil, Russia, Indonesia and Turkey, which were the top five GDP growth nations last year. Propelling growth in these countries is heavy investment in infrastructure, and Musikavanhu says that's not likely to slow down.

These days, some investors are tempted to invest in beaten-down single-country ETFs in Europe. Portugal and Spain are viewed as possibly the next dominoes to fall after Greece. But does that mean that you should buy, say, the iShares MSCI Spain Index Fund (EWP)?

Probably not. Spain, as well as Greece, Italy and Portugal all carry debt levels that exceed the requirements of the European Union. Despite the EU's $1 trillion rescue plan to prevent a widespread Eurozone crisis and save the euro, European ETFs have actually continued their decline because investors are still concerned about whether some of the weaker European countries will actually be able to cut their debt. The falling euro doesn't help, and individual countries such as Greece and Spain don't have independent control over their currency.

The upshot of all this: Most investors should probably avoid the riskiest European single-country funds for now, and unless you can handle the volatility, you may want to forgo single-country funds altogether. While the increased risk of single-country funds can also lead to a greater reward, a more palatable approach could be to reduce risk by focusing on regional ETFs.

Good options are Old Mutual's FTSE Emerging Markets Index (GSR), which invests in 20 different emerging-market countries, but is weighted more heavily in bigger nations like Brazil. Other options are Vanguard All-World Ex-U.S. ETF (VEU), which focuses on developed and emerging markets, and Vanguard Emerging Markets Stock ETF (VWO).